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Template:Isda 2(a)(iii) summ: Difference between revisions
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A financial asset that looks good, but thanks to a carefully buried [[conditions precedent]], is not there when you, and more importantly, your insolvency administrator, wants it.}} | A financial asset that looks good, but thanks to a carefully buried [[conditions precedent]], is not there when you, and more importantly, your insolvency administrator, wants it.}} | ||
{{drop|I|n the language}} of financial obligations, one’s rights to future payments under a contract are an asset. You own them and, all other things being equal, can ''deal'' with | {{drop|I|n the language}} of financial obligations, one’s rights to future payments under a contract are an asset. You own them and, all other things being equal, can ''deal'' with themcthat is, sell or raise money against them — the same way you can sell or mortgage a house, car, a portfolio of equities, or some [[Bitcoin|decentralised cryptographic tokens representing abstract capital]]. | ||
“Assets” have a few “[[ontological]]” properties, one of which is ''continuity'', in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still ''there'', at least until you do sell them. They therefore have some value to you, however parlous the state of your affairs might otherwise be. | “Assets” have a few “[[ontological]]” properties, one of which is ''continuity'', in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still ''there'', at least until you do sell them. They therefore have some value to you, however parlous the state of your affairs might otherwise be. | ||
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This continuity is important to the administration of failing enterprises wherever they are based, and so many countries have rules preventing company managers hurriedly disposing of their assets as impending disaster looms. Managers can’t therefore grant unfair preferences, by selling or giving away assets at an undervalue. And they can’t enter contracts, even in times of fair weather, which might have the effect of giving some creditors and counterparties unfair preferences over others, should the clouds roll in. | This continuity is important to the administration of failing enterprises wherever they are based, and so many countries have rules preventing company managers hurriedly disposing of their assets as impending disaster looms. Managers can’t therefore grant unfair preferences, by selling or giving away assets at an undervalue. And they can’t enter contracts, even in times of fair weather, which might have the effect of giving some creditors and counterparties unfair preferences over others, should the clouds roll in. | ||
Section {{{{{1}}}|2(a)(iii)}} has exactly that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA. Just when it goes insolvent or fails materially to perform, its “asset” represented by the {{{{{1}}}|Transaction}}, perhaps temporarily, vanishes. It allows a {{{{{1}}}|Non-defaulting Party}} to indefinitely suspend its performance of its obligations under a {{{{{1}}}|Transaction}} without terminating the {{{{{1}}}|Transaction}}. Should the {{{{{1}}}|Defaulting Party}} cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything but keeps the option to terminate (thereby crystallising the loss at any time. | |||
So an asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of existence at inopportune moments — especially at times of its owner’s existence fitfulness — is somehow imperfect: “flawed”. | So an asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of existence at inopportune moments — especially at times of its owner’s existence fitfulness — is somehow imperfect: “flawed”. | ||
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{{drop|W|w can have}} a fine time rabbiting away about the ontology of assets for sure, but isn’t there a more basic question: why would a Non-defaulting Party, presented with a counterparty in default, ever ''not'' want to just close out? | {{drop|W|w can have}} a fine time rabbiting away about the ontology of assets for sure, but isn’t there a more basic question: why would a Non-defaulting Party, presented with a counterparty in default, ever ''not'' want to just close out? | ||
It all comes down to ''[[moneyness]]''. The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of | It all comes down to ''[[moneyness]]''. The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of a swap {{{{{1}}}|Transaction}} means that either party may, net, be “[[out of the money]]” — that is, it would have to ''pay'' a net sum of money if the {{{{{1}}}|Transaction}} were terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement. | ||
So an [[out-of-the-money]], {{{{{1}}}|Non-defaulting Party}} has a good reason ''not'' to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain? | |||
On the other hand, the {{{{{1}}}|Defaulting Party}} is, er, ''ipso facto'', not holding up its end of the bargain. Just as our innocent {{{{{1}}}|Non-defaulting Party}} does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a {{{{{1}}}|Defaulting Party}} who isn’t paying anything back. | |||
A cleft stick. | |||
Section {{{{{1}}}|2(a)(iii)}} allows our {{{{{1}}}|Non-defaulting Party}} the best of both worlds. The [[conditions precedent]] to payment not being satisfied, it can just stop performing and sit on its hands — thereby neither crystallising its ugly [[mark-to-market]] position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it). | |||
So much so good for the {{{{{1}}}|Non-defaulting Party}}. | |||
This is, a bit dissonant, but there are far greater dissonances, so we park this one and carry on. | But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}. | ||
====Which events?==== | |||
Exactly which default events can trigger the suspension? Under the ISDA, {{{{{1}}}|Events of Default}} and even ''Potential'' {{{{{1}}}|Events of Default}} do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Events}} do not. This is because most {{{{{1}}}|Termination Events}} are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of ''Additional'' Termination Events, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on. | |||
We have seen valiant efforts to insert Additional Termination Events to section 2(a)(iii), and “Potential Additional Termination Events”, a class of things that does not exist outside the laboratory, so must therefore be defined. All this for the joy of invoking a clause that makes little sense in the first place. | |||
====2(a)(iii) in a time of Credit Support==== | ====2(a)(iii) in a time of Credit Support==== | ||
Flawed assets entered the argot in a simpler, more (''less''?) peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were an unusual sight. Nor, in those times, were dealers often of the view that they might be on the wrong end of a flawed assets clause. They presumed if anyone was going bust, it would be their client. Because — the house always wins, right? The events of [[Global financial crisis|September 2018]] were, therefore, quite the chastening experience. | Flawed assets entered the argot in a simpler, more (''less''?) peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were an unusual sight. Nor, in those times, were dealers often of the view that they might be on the wrong end of a flawed assets clause. They presumed if anyone was going bust, it would be their client. Because — the house always wins, right? The events of [[Global financial crisis|September 2018]] were, therefore, quite the chastening experience. | ||
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This presented dealers with an unusual scenario: what happens if ''you'' blow up when ''I'' owe you money? I might not want to crystallise my contract: that will involve me paying you a [[mark-to-market]] replacement cost I hadn’t budgeted for paying out just now. (This is less true in these days of mandatory [[variation margin]] — that is one of JC’s main objections — but the {{isdama}} was forged well before this modern era). | This presented dealers with an unusual scenario: what happens if ''you'' blow up when ''I'' owe you money? I might not want to crystallise my contract: that will involve me paying you a [[mark-to-market]] replacement cost I hadn’t budgeted for paying out just now. (This is less true in these days of mandatory [[variation margin]] — that is one of JC’s main objections — but the {{isdama}} was forged well before this modern era). | ||
The ISDA answers this with the “[[flawed asset]] | The ISDA answers this with the “[[flawed asset]]” provision of Section {{{{{1}}}|2(a)(iii)}}. This allows an innocent, but [[out-of-the-money]], party faced with its counterparty’s default, to not close out the ISDA, but just freeze its own obligations until the default situation is resolved. | ||
There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it. | There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it. | ||